This site uses cookies to store information on your computer. Some are essential to make our site work; others help us improve the user experience. By using the site, you consent to the placement of these cookies. Read our privacy policy to learn more.

Accounting for Asset Retirement Obligations

FASB 143 explains it all.

TO PROVIDE BUSINESSES WITH GUIDANCE
ON WHEN and how to recognize a liability
for asset retirement obligations, FASB issued
Statement no. 143, Accounting for Asset
Retirement Obligations. The statement applies
to retirement obligations for tangible long-lived
assets.

THE STATEMENT REQUIRES ENTITIES TO
RECOGNIZE asset retirement obligations
at their fair value—the amount at which an
informed willing party would agree to assume the
obligation. Such a market may not always exist so
CPAs might need to estimate fair value. A present
value technique may be the best approach.

MANY ENTITIES HAVE HISTORICALLY
ACCOUNTED FOR retirement obligation
costs as part of depreciation. Differences between
liability accounting under Statement no. 143 and
depreciation accounting arise due to the timing
and classification of a retirement cost liability
and asset and their attendant expenses.

COMPANIES MUST IMPLEMENT STATEMENT
NO. 143 for fiscal years beginning
after June 15, 2002. To implement the statement, a
company will need to follow certain steps,
including determining whether it has legal
obligations related to the retirement of
long-lived assets. This “scope” issue will require
CPAs to do careful research.

THE SWEEPING CHANGES IN STATEMENT
NO. 143 provide a mechanism for
ensuring that companies’ balance sheets more
clearly reflect the economic realities of the
retirement obligations associated with long-lived
assets. The changes could be particularly
significant for capital-intensive industries.

ERIC R. ALEXANDER,
CPA, CMA, CFM, is a self-employed consultant in
Canyon, Texas, specializing in financial management,
business valuation and strategic planning. His
e-mail address is ericralexander@msn.com
. RONALD R. HINER, CPA, EdD, is a professor of
accounting at West Texas A&M University in
Canyon. His e-mail address is rhiner@mail.wtamu.edu
.

ith the long-term business trend
toward a more balance-sheet oriented focus in
accounting, FASB has fixed its attention on how
entities account for obligations associated with the
retirement of tangible long-lived assets. In the
past, many businesses employed an income-statement
approach, recognizing the costs related to such
obligations ratably over an asset’s life as a
component of depreciation or expensing the
obligations as they are incurred. FASB Statement no.
143, Accounting for Asset Retirement
Obligations— which was seven years in the
making—shifts to a balance-sheet approach, requiring
businesses to recognize a liability for a retirement
obligation when they incur it—even if that is far in
advance of the asset’s planned retirement. This
article explains the provisions of Statement no. 143
as companies and their accountants will need to
apply them.

OVERVIEW OF FASB 143

In FASB’s words,
Statement no. 143’s stated objective is to
“establish accounting standards for recognition
and measurement of a liability for an asset
retirement obligation and an associated asset
retirement cost.”

The new rules regarding
the retirement of tangible long-lived assets
include these features:

A business must recognize an asset
retirement obligation for a long-lived asset at
the point an obligating event takes place—provided
it can reasonably estimate its fair value (or at
the earliest date it can make a reasonable
estimate).

The entity must record the obligation
at its fair value, either the amount at which the
liability could be settled in a current
transaction between willing parties in an active
market, or—more likely—at a substitute for market
value, such as the present value of the estimated
future cash flows required to satisfy the
obligation.

To offset the credit portion of the
asset retirement liability entry, businesses must
capitalize the asset retirement costs as an
increase in the carrying amount of the related
long-term asset.

Businesses must include certain costs
in the income statement during the asset’s
life—namely depreciation on the asset, including
additional capitalized retirement costs, and
interest for the accretion of the asset retirement
liability due to the passage of time.

RECOGNITION ISSUES

Statement no. 143
applies to tangible long-lived assets, including
individual assets, functional groups of related
assets and significant parts of assets. It covers
a company’s legal obligations resulting from the
acquisition, construction, development or normal
operation of a capital asset. In many cases, the
presence or absence of a qualifying legal
obligation will be clear. Other situations will
require CPAs to carefully analyze the
circumstances and the statement’s detailed
guidance.

The statement provides other
guidance on the new standard’s scope:

A mere plan or intention to dispose
of an asset does not require recognition.

Obligations—such as environmental
remediation liabilities—related to the improper
operation of an asset are not covered.

Businesses may incur retirement
obligations at the inception of an asset’s life or
during its operating life. For example, an
offshore oil-and-gas-production facility typically
incurs its removal obligation when it begins
operating. A landfill or a mine, however, may
incur a reclamation obligation gradually over the
life of the asset as space is consumed with waste
or the mine is dug. In other cases, the obligation
may come because of the passage of laws or
regulations during an asset’s life, such as
environmental regulations.

MEASUREMENT ISSUES

Under Statement no.
143, an entity must recognize an asset retirement
obligation at its fair value—the amount at which
an informed willing party would agree to assume
the obligation. However, acknowledging that a
market for settling such obligations may not
exist, FASB permits CPAs to estimate the
obligation’s fair value and says that a present
value technique is often the best approach.

An entity must estimate the cash flows required
to settle a retirement liability and make those
estimates consistent with information and
assumptions “marketplace participants” would use.
Companies should not allow proprietary information
and internal cost structures to influence the cash
flow estimates if they differ materially from
market conditions.

Companies must also
estimate the amount and timing of the related cash
flows, incorporating explicit assumptions about
inflation, technology advances, profit margins,
offsetting cash flows and other factors. A single
point estimate of value based on these assumptions
apparently will not suffice. A company must
determine the extent to which the amounts or the
timing would vary under different future scenarios
and the relative probabilities of each.

The scenarios CPAs consider in the present
value calculation reflect uncertainties about
settling a retirement obligation. These
uncertainties do not, however, play a part in a
company’s decision whether to recognize the
liability—assuming the obligation’s existence is
otherwise clear.

Companies must discount
the estimated cash flows, with all their
assumptions, probabilities and uncertainties,
using what Statement no. 143 calls a
credit-adjusted risk-free rate —a rate
(such as that for zero-coupon U.S. Treasury
instruments) adjusted upward for the effect of the
entity’s credit standing. A liquid, solvent,
relatively unleveraged company—one with a strong
credit standing—would have a smaller adjustment
than an entity that is less creditworthy.

All these features—assessing what the market
“believes” about costs, anticipating inflation
rates and technology advances, estimating
probabilities for various scenarios and
determining a credit-standing adjustment for the
discount rate—combine to create a very subjective
value. Yet, in the absence of an active market,
such a present value technique should, if CPAs
apply it properly, produce a reasonable and
defensible substitute for fair value.

AN EXAMPLE

Exhibit
1 and exhibit
2 demonstrate Statement no. 143’s accounting
treatment using a sample asset. The asset’s
carrying cost includes the $1 million original
cost plus the capitalized retirement cost—equal to
the initial liability amount—of $162,892. The
retirement entry of the long-lived asset would be
as follows, assuming the actual cash flows to
settle the retirement obligation match those
estimated. (In this and following balance-sheet
illustrations, debits are denoted by “Dr.” and
credits by “Cr.”)

Any differences between the
asset retirement liability balance and the actual
retirement costs would flow through the income
statement as a gain or loss on retirement.

COMPARISON TO DEPRECIATION ACCOUNTING

Historically, many
entities have accounted for retirement obligation
costs as a part of depreciation.
Depreciation-based accounting includes the
estimated and undiscounted cash flows
related to retirement in the depreciable base
allocated over the asset’s useful life.
Depreciation calculations also include estimated
salvage proceeds. For most of the assets Statement
no. 143 affects, retirement costs far exceed
salvage, resulting in what some industries refer
to as negative net salvage and also yielding a
depreciable base—original cost plus estimated
removal costs less estimated salvage—that exceeds
the long-lived asset’s original cost. Exhibit
3 summarizes depreciation accounting for the
sample asset (note Statement no. 143 has
superseded the treatment of obligatory removal
costs shown here).

At the end of the
sample asset’s life, both depreciation accounting
and the liability approach Statement no. 143
mandated yield the same net credit on the balance
sheet. The accounting shows the credit as a
liability ( exhibit
2 : net book value of zero less the $422,500
retirement liability), whereas depreciation
accounting results in a negative—and
counter-intuitive—net asset balance ( exhibit
3 : asset balance of $1 million less
accumulated depreciation of $1,422,500, and no
retirement liability).

Both approaches
recognize the same total expenses—$1,422,500—over
the asset’s useful life. Under Statement no. 143,
the expenses are made up of $1,162,892 in
depreciation plus $259,608 of interest accretion
(see exhibit
2 ), while depreciation expense is the only
income-statement item for the depreciation
accounting approach (see exhibit
3 ).

The differences between
liability accounting under Statement no. 143 and
depreciation accounting arise within the asset’s
life due to the timing and classification of the
retirement cost liability and asset and their
attendant expenses.

In most cases these
timing differences cause the pattern of expense
recognition to shift from a flat line under
depreciation accounting (straight-line
depreciation of a base that includes an estimate
of the retirement costs) to an upward-trending
expense line under liability accounting
(straight-line depreciation plus ever-increasing
interest accretion resulting from the passage of
time).

KEY VARIABLES

In implementing
Statement no. 143, CPAs may have to make some
potentially complex calculations that are highly
sensitive to several variables.

Cash flow estimates. The
timing and amounts of the cash flows to cover the
actual costs of retiring an asset and settling the
retirement obligation can vary widely. Assets such
as electric power plants, oil refineries and mines
usually have long lives. Predictions out 30 to 40
years or more inevitably will be fuzzy. Yet
entities required to implement Statement no. 143
must make educated guesses about inflation rates,
labor costs, technological advances and profit
margins in a way that reflects how the market
would view such items.

Despite the
inherent subjectivity, this often is the only
practical approach for a company to take when
implementing Statement no. 143. These estimates
require CPAs to do careful analysis and
documentation, including supportable underlying
assumptions.

Credit-adjusted, risk-free rate.
Companies must apply a “level
effective interest rate.” They apply this rate to
a liability balance that grows each year—as
interest is added, the annual interest expense
(accretion) also grows. The steepness of this
expense line depends on the discount rate: the
higher the rate (the credit-adjusted, risk-free
rate), the deeper the discounting.

Deep
discounting has three effects: (1) It creates a
smaller amount of retirement costs for a company
to capitalize as part of the asset’s carrying
cost, rendering the more stable component of
annual expense—depreciation—less significant; (2)
it results in much smaller interest expense via
accretion in the early years because the initial
liability is smaller; and (3) it yields greater
variation in accretion costs from early in the
asset’s life to later. Exhibit
4 shows various annual expense lines for the
sample asset.

THE EFFECTS OF PAST DEPRECIATION
PRACTICES

Statement no. 143 requires companies to make a
“cumulative-effect” entry when they implement its
provisions. FASB decided that, at transition, an
entity should measure the fair value of a
liability for an asset retirement obligation and
the corresponding capitalized cost at the date the
liability was initially incurred using current
information, assumptions and interest rates.
Companies should use that initial fair value and
initial capitalized cost as the basis for
measuring depreciation and interest expense from
the date the liability was incurred to the date of
the statement’s adoption.

The result:
“immediate recognition…of liability, asset, and
accumulated depreciation amounts” with the net
amount flowing through that period’s income
statement as a cumulative-effect adjustment. For
entities that had not previously provided for
retirement costs, this cumulative effect could be
sizable.

If a company owning the sample
asset had not included any provision for
retirement costs in its annual depreciation
amounts, its accumulated depreciation balance at
the end of year 4 would be $400,000 ($1 million
original cost over 10 years X 4 years of
depreciation). The company would record the
following transition entry assuming implementation
at the end of year 4 (see exhibit
2 for the balances required at that point):

If the same company had
included the asset’s estimated retirement costs in
its depreciable base (as shown in exhibit
3 ), the cumulative effect adjustment upon
transition at year 4 would actually be a net
credit flowing through the income statement, as
follows (see also exhibit
5 ):

The cumulative effect
amounts flowing through the income statement
represent, in each case, the net offset to the
combined adjustment of the relevant balance-sheet
items as well as a catch-up for the cumulative
differences in income statement amounts recorded
under the differing accounting approaches.

Because the circumstances surrounding a
business and its major assets will vary widely,
the effect of adopting Statement no. 143 also will
vary. The interplay of the factors
involved—particularly the credit-adjusted,
risk-free discount rate, the age of the asset
relative to its overall useful life, cash flow
estimates and the adequacy of prior provisions for
retirement costs—means each situation requires
CPAs to do careful analysis.

ACTION ITEMS

Companies will find Statement no. 143’s new
approach to accounting for asset retirement
obligations has these important implications:

A shift in the components and
stability of period expenses.

A change in balance-sheet
components—adding a new liability and capitalized
retirement costs as part of the carrying cost of
the long-lived asset, and removing accumulated
depreciation of retirement-related costs embedded
there. (Note: This is the case only for costs
related to retirement obligations covered by
Statement no. 143; retirement costs not related to
obligations presumably may remain a component of
depreciation accounting.)

To
prepare to implement Statement no. 143—required
for fiscal years beginning after June 15,
2002—entities with long-lived assets need to
perform the steps listed below. (In many cases,
CPAs will need to apply these steps for a
company’s significant individual assets on a
stand-alone basis.)

1. Using the specific guidance in
the statement, determine whether the entity has a
legal obligation related to retirement of the
long-lived asset. This essential scope issue will
require CPAs to do research in many instances.

2. Use market information, if
possible, to value an obligation. Otherwise,
follow these three steps:

Estimate how “market participants”
likely would view the costs and circumstances
related to the retirement obligation (for example,
labor rates, cost structures and technological
advances). Since the statement does not provide
any explicit guidance on how CPAs would do this,
practice will vary depending on the circumstances.

Prepare a range of estimated cash
flows related to settlement of the obligation and
weight them for their probabilities of occurrence.

Discount the probability-weighted
cash flow data to the date the liability was
incurred using a risk-free interest rate adjusted
for the entity’s credit standing.

4. Prepare a cumulative-effect
adjustment entry reflecting the requisite
balance-sheet amounts, with the net difference
flowing through the income statement.

5. Prepare the required financial
statement disclosures (a general description of
the asset retirement obligation and of the
associated asset; the value of any assets legally
restricted for purposes of settling the
obligation; and a reconciliation of the asset
retirement liability balance for the period).

6. Adjust depreciation rates for
long-lived assets for which the estimated
retirement obligation was part of the depreciable
base.

Ongoing accounting oversight for
these long-lived assets and their retirement
obligations requires CPAs to be alert to changes
in the cash flow estimates—their amounts, timing,
probabilities and market expectations. Such
changes, if material, are treated as a change in
estimate: CPAs evaluate the new data to determine
adjustments to make to the liability and
capitalized cost balances (with prospective
effects on income-statement items).

A CLEAR REFLECTION

Statement no. 143
imposes sweeping changes in how companies—and
their CPAs—will have to account for asset
retirement obligations. For capital-intensive
entities in particular, these changes require
significant analysis, the likelihood of procedural
changes and, depending on past accounting
practices, the possibility of material transition
charges. However, and this represents the benefit
that FASB believes justifies and outweighs those
costs, the new statement provides a mechanism for
ensuring that companies’ balance sheets reflect
more clearly the economic realities of retirement
obligations associated with long-lived assets.

Are you working with the best technology? Do you know how to help your clients determine if their technology stack measures up? In this free report, J. Carlton Collins, CPA, explains how to answer those questions via a technology assessment engagement.